Choosing Your Game

by: Edward Schneider, CFA

Successful investing depends not only on how smart you are, but who you are competing with. A certain skill level is a prerequisite to effectively compete. In fact, for all but the largest investment groups, specialization in a particular area helps maintain that information edge over other investors. Yet, the most important source of alpha returns, in my experience, has been choosing the less-followed path that avoids mainstream competition.

On a historical-return basis, Ibbotson data shows that on average, small-caps have outperformed large-caps by 2% points per annum since 1926. These higher small-cap returns, however, were achieved with higher volatility. Thus, there is no free lunch, and risk-adjusted returns are roughly in line.

Asset Comp Annual Returns 1926-2012 Volatility Rank
Small Stocks 11.9% 1
Large Stocks 9.8% 2
LT Government Bonds 5.7% 3
T-Bills 3.6% 5
Inflation 3.0% 4

Small-cap stocks are less followed than their large-cap brethren, leading to a greater potential of mispriced assets and alpha returns. Below are examples of two technology large-caps and their small-cap competitors, showing much higher institutional ownership and exponentially more analysts for the large-cap stocks.

Company Sector Market Cap EV/Revs # of sell-side analysts Institutional Ownership
Intel (NASDAQ:INTC) Semiconductor $112B 2.1x 68 69%
Sequans (NYSE:SQNS) Semiconductor $0.09B 4.2x 5 45%
Oracle (NASDAQ:ORCL) Software $154B 3.8x 62 64%
Attunity (NASDAQ:ATTU) Software $0.07B 3.1x 0 10%

One could conclude that small-caps' higher historical returns and less efficient pricing create more fertile ground for investment than that of their large-cap counterparts. The rub is that the small-cap risk/volatility is higher, so one would need to have a sustainable information edge to take full advantage of this higher risk/return scenario.

In a universe of only large and small caps, the small-cap universe would be a more attractive game to play, assuming a certain skill level. But both games are relatively more difficult than some other lesser-known games. As a manager of a crossover fund that invests in small-cap and private technology companies, I can attest that the small-cap market is more efficient than many would assume. Even stocks like Attunity with no sell-side coverage, have some fairly savvy buy-side investors who follow the stock quite closely. Attunity shares are volatile but are generally efficiently priced. Furthermore, many small-cap stocks have some institutional coverage, and there is little incremental efficiency gain from going from a few analysts to several more.

The main fundamental way to make money in small-cap as well as large-cap stocks is to have an information edge and related vision of the company's realizable potential, and try to hold the stock until that value is obtained. Given the base effect, the growth potential is higher for small caps than large caps. Thus, an investor taking a correct long-term view on a small-cap would provide outsized returns relative to that of a large cap. So even though it is still a difficult game, we have found the small-cap technology sector to be attractive given our sector expertise.

That said, we have generated some nice alpha returns in recent years by shorting grossly overvalued stocks mainly in the technology sector that primarily trade on the OTCBB and Pink Sheet market exchanges.

# of alpha shorts Avg. Ent. Value Avg. EV/Revs Cash Flow Outlook
15 $290M 4000x All negative Awful

Fundamentally, these stocks are at best worth a small fraction of their enterprise values. They have virtually no revenues, no real assets, dysfunctional business models, and are hemorrhaging tons of cash. Over time, these extremely overvalued shorts succumb to gravity (and are replaced by new bubble stocks).

Overvaluations of these proportions just do not exist in the mainstream investment game. But they do exist elsewhere - see It's Shorting Season for recent examples.

Efficient market theorists would have difficulties explaining such a valuation divergence between our shorts and other stocks within the same technology sector. Segmentation of investors can partially explain this anomaly: traditional exchanges like the NYSE and Nasdaq have more discriminating institutional investors, while the less-regulated OTCBB market mostly has less-sophisticated retail investors who are more moved by a promotional story and a chart than by underlying fundamentals. Secondly, finding and reliably borrowing these primarily OTCBB alpha shorts is not easy; if it was that simple, then they probably would not be so overvalued. Despite the obstacles, shorting these retail-driven investment scams has been a relatively easier game for us to play so far.

Fund/Index 2013 1H 2012 2011 2010
Quan Stocks Shorts +4% +13% +56% +9%
DJ Dedicated Short Index -12% -16% -12% -18%
Nasdaq +13% +16% -2% +17%

The greatest returns we have achieved over the long run have been in the private technology field. In venture, taking the path less followed has been a key to our success. For example, we spent the last few years building up expertise in various up-and-coming technology sectors like Big Data (see Tech Trends: Reflections From The Road Part I) and Software Defined Networks (see SDN World Conference Notes). But we were already too late. The first-movers were already established. The valuations were way too high for the leading companies; larger venture investors were already swarming all over them and/or creating me-too companies with slightly different spins. We have also spent time on more bleeding-edge technologies that are farther out such as medical-semiconductor crossovers.

Just by chance, we came across a semiconductor equipment company that was not on most other investors radar screen. Semiconductor equipment is an anathema for most venture firms. High capital costs and difficult technology hurdles scare off most VCs. But this company's unique and scalable technology was going to revolutionize the $1.6B gas flow controller industry, and make it the standard for next-generation fabs. Furthermore, the valuation was attractive, so that if the company executes, we will make a large multiple on our investment. In sum, the semiconductor equipment game is an easier game to play at this point in time, compared to the more popular investment themes.

For investing in general, and venture in particular, it helps to be lucky. Which company gets taken out in an attractive trade sale (e.g. Nicira being acquired by VMware (NYSE:VMW) for $1.2B), while others suffer (e.g. leading SDN peers like Big Switch that are now facing a difficult battle), can be a real crapshoot. Even for our gas flow controller investment, there are variables that we cannot control, and we will need some luck; but at least the odds are in our favor.

Two roads diverged in a wood, and I--
I took the one less traveled by,
And that has made all the difference.

Robert Frost

NB: For a more in-depth study on this subject, I recommend reading Michael Mauboussin's book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, and his recent article Alpha and the Paradox of Skill.

Disclosure: I am long ATTU, SQNS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.